Caution's the word as Fed wraps up meeting

No major change expected in central bank's message on U.S. economy and rates

WASHINGTON (MarketWatch) -- As they wrap up a two-day meeting to review the U.S. economy, interest rates and monetary policy, Federal Reserve officials are expected to issue a cautious statement keeping rates on hold at record-low levels, analysts said.

The Fed has kept interest rates near zero since December 2008. Although there has been much talk recently about an exit strategy for the Fed, many economists have pushed back their estimates of when a tightening campaign might begin well into next year.

With virtually no chance of a major change in the pledge to keep rates low for an "extended period," all eyes will be on the Fed's description of current economic conditions Wednesday afternoon.

For the most part, economists expect the Fed's to express just a bit more concern about the outlook.

The Federal Open Market Committee will issue a statement accompanying its decision on rates at 2:15 p.m. Eastern.

In its last statement in April, the Fed noted that the economy "continued to strengthen." Many Fed watchers believe that the central bank will soften that optimism, based on the tone of recent economic data.

The backdrop since the FOMC's last meeting in April has been eventful, dominated by turbulence in the financial markets arising from the European debt crisis. At the same time, key U.S. economic data -- including unemployment and retail sales -- have been decidedly soft.

Decelerating inflation will give FOMC members great latitude in keeping the fed funds rate at its current low level, wrote Brian Fabbri, U.S. economist at BNP Paribas in New York, in a note to clients.

Meanwhile, Fed watchers are wondering whether Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, will continue to dissent from the zero-interest rate policy.

Hoenig, who has dissented at every Fed policy meeting this year, is on record as worried that the ultra-low interest rates might foster another asset bubble.

Joseph LaVorgna, chief U.S. economist at Deutsche Bank, said if Hoenig doesn't dissent, it would show that the Fed's very worried about the European debt crisis and the possibility of further drop in inflation.

The goal of Fed officials at their meeting over Tuesday and Wednesday is to make as few waves as possible, not wanting to add any uncertainty that could distract financial markets or stall the fragile recovery, observers said. Fed to hide in plain sight.

"This is going to be one of the most boring meetings ever. They just don't want to rock the boat," said Michael Moran, chief economist at Daiwa Securities.

Evolution in Fed's thinking

Dull it may be, but this also punctuates a remarkable shift in thinking from Fed watchers.

For months, analysts had expected the FOMC's June meeting to be pivotal. It was seen as the ideal time for the Fed to describe plans to raise short-term interest rates, perhaps by the end of the year.

Bernanke has to go before Congress in July to discuss monetary policy, and the feeling earlier had been that Bernanke would use the appearance to explain why rates must move higher.

All this has now changed.

Currently, just two of 18 economists from the biggest U.S. bond dealers expect any move on rates and monetary policy from the Fed this year. Most think rates won't move for a year -- and some are even pushing rate hikes back to 2012. See recent survey of top economists

"We are simply not at a point where the Fed needs to make meaningful adjustments [to its statement]," said economists at RBC Capital Markets.

Concern about how the European debt crisis will influence the U.S. economy has had the effect of driving the Fed to the sidelines, analysts said.

But domestic concerns are also keeping the Fed on hold: The unemployment rate, which ran at 9.7% in May, has barely budged this year.

"If there were a doomsday clock for the zero-rate policy, the hands would be set to tick on pace with one critical variable: jobs," said Avery Shenfeld, chief economist at CIBC World Markets in Toronto.

"Consumers won't be in a position to spend on a sustained basis until we have the job creation needed to support income gains. And inflation will hardly be a threat in an economy where massive labor-market slack is suppressing wages and pushing core inflation lower," he said.

Deliberating the double-dip scenario

Behind the scenes, there is growing tension among top Fed officials, said former Fed governor Lyle Gramley.

Some are getting anxious about maintaining the low rate policy that has been in place since December 2008. Others are worried the economy may weaken, he said.

"I'd love to be a fly on the wall," said Gramley.

A recent article by the San Francisco Fed suggested the FOMC should wait until 2012 before raising its policy target rate. This added to the sense the Fed is firmly on hold.

Many analysts expect the Fed's policy statement to be more dovish. Fed officials will likely to discuss how they might react to a double-dip recession.

"The Fed probably feels that the challenge ahead of it is to find ways to strengthen its support for financial markets if the need should arise," said Wrightson ICAP's Crandall.

But not all economists believe the Fed is on hold as far as the eye can see.

Economists at Morgan Stanley, think the contagion risks from Europe are overblown, are forecasting solid U.S. growth in gross domestic product with inflation also moving higher. As a result, the Fed will move quickly and hike rates over 1% by the middle of 2011, they said.

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